Banks caught in DVA dilemma

Accountants want banks to report as profits the impact of widening credit spreads on their liabilities, but regulators are moving in the other direction. The result could be painful deductions from capital, and two very different sets of incentives

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Banks caught in DVA dilemma

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Banks caught in DVA dilemma

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The idea of banks booking profits as their credit deteriorates does not sit comfortably with many people – even less so after this accounting concept, the debit value adjustment (DVA), generated combined earnings of $9.35 billion at five US banks in the third quarter of 2011. To critics, these numbers are fictitious, but truth is secondary to consistency for a senior risk manager at one US bank.

“I don’t care about truth in accounting rules. I have to use it, it goes into my reports, I’m charged tax on it – and that makes it real. All I ask is that the numbers I have are consistent – in reporting and in capital,” he says.

He may be disappointed. Accounting standard-setters on both sides of the Atlantic have embraced DVA as a component of financial reporting, the argument being that as a bank becomes more likely to default, the value of its derivatives liabilities and other obligations should be reduced, generating a profit. If they came from other sources, those profits would count towards equity, and would therefore contribute to the calculation of regulatory capital ratios. But the Basel Committee on Banking Supervision is considering hardening its stance that changes in DVA be excluded from these calculations. That could remove billions of dollars from the industry’s stock of capital, hurting US institutions – where accounting standards require DVA to be reported and regulators allow it into bank capital numbers – more than European ones, where practices are mixed.

Currently, Financial Accounting Standard (FAS) 157, the US rule on fair value measurement, requires changes in derivatives DVA to be reported as profits and losses, while firms also have the option to report own-credit effects on other liabilities. That includes any profits from the initial DVA at the trade’s inception – as part of an option’s premium, for instance.

Fair value measurement in many other countries, including the whole of the European Union, is currently governed by International Accounting Standard (IAS) 39, which takes the same broad position as the US rule but has produced a range of interpretations because of a subtle difference in wording: unlike FAS 157, it requires own-credit effects on liabilities to be calculated as a settlement price rather than a transfer price.

Put simply, if a bank is out-of-the-money on a derivatives contract, settling that liability could mean paying its obligation in full – it is not obvious the value would be affected by the bank’s own credit. In contrast, if the trade was transferred to another bank – assumed to be of the same quality – any change in the creditworthiness of the first institution during the life of the trade would need to be reflected in the transfer. This ambiguity should be removed from the start of 2013, when IAS 39 is replaced by International Financial Reporting Standard (IFRS) 13, which requires the use of a transfer price.

“Under IAS 39 you could make the argument that as the fair value of a derivatives liability is valued by a settlement value, it doesn’t need to include a credit adjustment – and while many European banks include it, many others don’t. It’s much clearer under IFRS 13 that derivatives must include a DVA, because the standard insists on a transfer value,” says Tony Clifford, a London-based partner at Ernst & Young.

That should result in DVA becoming a bigger component of European bank earnings, say analysts at JP Morgan Cazenove, in a January 27 report. “Assuming IFRS preparers apply IFRS 13 in the same way as its US equivalent has been followed by US banks, we can expect to see more DVA gains and losses being calculated and disclosed in 2013,” the report says.

Opposing view

Bank regulators, though, have been moving in the opposite direction. In 2004, the Basel Committee issued a press release in which it said supervisors were concerned about accounting gains and losses generated when fair-valuing liabilities, and that they should be excluded from equity capital. It followed this up with a guidance note in 2006.

Despite this guidance, many national regulators continue to allow DVA to be included in equity. The US bank’s risk manager says his institution counts derivatives DVA towards its capital ratio, but excludes other liabilities – a Federal Reserve policy mirroring the distinction in FAS 157. A spokesperson for the Swiss regulator, Finma, confirms it allows its banks to include DVA in equity capital ratios.

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